RRSPs: Worth it in the long run?

RRSPs: Worth it in the long run?In my last blog post, I compared RRSPs with TFSAs. I thought it would be a good idea to follow that up by expanding on the program Canadians are most familiar with… the RRSP. You may have a rough idea of how RRSPs work, but do you have a grasp on how these investments fit into your overall financial plan and life?

For many of us, there are two compelling reasons to invest in an RRSP. First, you can dramatically reduce your tax bill by making a contribution. Second, you can accumulate wealth within your RRSP without being taxed, at least until you eventually withdraw funds. Both of these things make the RRSP a valuable tool when it comes to preparing for retirement.

If you’re not familiar with how your contribution affects your taxes, below is a simple example for someone earning $100,000 and paying the 2013 Ontario “marginal” tax rate of about 43%.

Income $100,000
RRSP contribution $10,000
New taxable income $90,000

In this example, the tax savings on a $10,000 RRSP contribution would be $4,300 ($10,000 x 43%).

On the other hand, if you’re retired and need to withdraw funds from your RRSP for additional income, your taxes would go up. For example, a person living in Ontario with an existing income of $70,000 (tax bracket of about 33%) and withdrawing $10,000 from their RRSP would see something like this:

Income $70,000
RRSP withdrawal $10,000
New taxable income $80,000

In this example, the additional tax on a $10,000 RRSP withdrawal would be about $3,300 ($10,000 x 33%).

The benefits of RRSP loans

There’s more to RRSPs than just contributions and withdrawals. I recently mentioned to a friend that I would likely need to complete some RRSP loans for my clients before the March 3rd deadline. To my surprise, my friend asked me how such a loan could benefit my clients.

Here are two examples of how an RRSP loan could be beneficial:

Example 1 - In this example, the investor has no existing contributions, no liquid funds and would like to minimize their monthly payments while maximizing their RRSP contributions:

Income $100,000
RRSP loan A (1-year term) $10,000
RRSP loan B (1st payment due 90 days after loan) $7,000
New taxable income $83,000
  • The tax savings on $17,000 in RRSP loans would be $7,310 ($17,000 x 43%).
  • Loan A is paid back in 12 months at $849.22/month (which includes interest of 3.5%). The total cost of this loan is $10,190.64.
  • Loan B is due within 90 days. It is paid back with the tax return from the government at a total cost of $7,165.17 (including interest).

By setting up a second loan in which the payments are due after the investor receives their tax return, the investor is able to benefit from $17,000 in loans—although they only needed a $10,000 loan. The investor can use their tax return to pay the second loan off before any monthly payments are due.

Example 2 - In this example, the investor has $10,000 of existing contributions, needs to make an additional contribution and has no liquid funds:

Income $100,000
RRSP contribution $10,000
RRSP loan $7,000
New taxable income $83,000
  • The tax savings on a $17,000 RRSP contribution ($10,000 existing contribution plus the $7,000 loan) would again be $7,310 ($17,000 x 43%).
  • This $7,310 tax savings would be more than enough to pay back the $7,000 loan on the spot plus $165.17 in interest.

Are RRSPs worth it in the long run?

One common complaint about RRSPs is that they may not be worth it, because you do have to pay the tax back at some point. However, I would argue that for most of us, our income (and tax brackets) will be higher during our contributing years than they will be when we’re withdrawing funds. That gives us a net tax benefit. Even if your tax bracket remains the same, investing in an RRSP is still advantageous because your investment can grow tax-free. Also, the money you save on your taxes today can be invested and allowed to grow for many years, so it will be worth substantially more 20 years from now.

This post is not meant to be a comprehensive review of RRSPs, but it is meant to give you some ideas that may be helpful. As mentioned in myprevious blog post, RRSPs may not be the best strategy for business owners or doctors who are incorporated given the other strategies available to them. To get the best idea of how your RRSPs can work for you, please talk to your financial advisor.